Introduction

The Financial System

The Financial System An Introduction

A financial system plays a vital role in the economic development of any country. It facilitates the flow of funds from the savers to those who borrow to invest in any productive ventures. It mobilizes and usefully allocates the scarce resources of a country. A financial system is a complex, well integrated set of subsystems of financial institutions, financial markets, financial instruments and financial services which facilitates the transfer and allocation of funds, efficiently and effectively, and in the best interests of all the stakeholders.

Formal & Informal Financial Sectors

The formal financial sector is characterized by the presence of an organized, institutional and regulated system which caters to the financial needs of the modern spheres of the economy. The informal financial sector is an un organized, non institutional, and non regulated system dealing with the traditional and rural spheres of the economy. The co existence of the formal and informal sectors is commonly referred to as FINANCIAL DUALISM. The informal sector has emerged as a result of the intrinsic dualism of economic and social structures of developing countries and the financial repression which prevents certain under privileged sections of the society from accessing funds from the formal sector.

Formal & Informal Sectors ( cont )

The informal sector is characterized by flexibility of operations and interface relationships between the creditor and the debtor. The advantages of the informal sector are low transaction costs, minimal default risk, and the transparency of procedures. Due to these advantages, a wide range and higher rates of interest prevail in the informal sector. An interpenetration is found between the formal and informal sectors in terms of operations, participants, nature of activities, which in turn have led to their co existence. A high priority should be accorded to the development of an efficient formal financial sector as it can offer lower intermediation costs and provide services to a wide base of savers and entrepreneurs.

The Indian Financial System

The Indian Financial System also can be classified into formal and informal sectors. The formal financial sector comes under the purview of Ministry of Finance, RBI, SEBI, IRDA and such other regulatory bodies. The informal sector consists of individual money lenders ( including neighbors, friends , relatives and traders ) and groups of persons operating as funds or associations. These groups of persons function under a set of their own rules and use names such as fixed funds, associations and savings clubs. Partnership firms consisting of local brokers, pawn brokers and non bank financial intermediaries such as finance, investment companies and chit funds also form a part of the informal financial sector.

Components Of Formal The Financial system

The formal financial system consists of four important segments or components Financial Institutions Financial Markets Financial Instruments Financial Services

Financial Institutions
These are intermediaries that mobilize the savings in the economy and facilitate the allocation of funds in an efficient manner. Financial institutions can be classified as Banking and Non Banking Financial Companies. Banking Companies are creators and purveyors of credit while Non Banking Financial Companies are only purveyors of credit. While the liabilities of the banks are part of the money supply, this may not be true of non banking financial companies.

Financial Institutions ( continued )

In India, the major institutional purveyors of credit are i) Banks SBI Group, Public and Private sector Banks, Co op Banks, RRBs, ii) NBFCs Non Banking Finance Companies , iii) DFIs - IFCI, IDBI, SIDBI, NABARD, NHB, TFCI, IIFCL, EXIM BANK Etc. Investment institutions such as UTI, LIC, GIC, Public and Private Mutual Funds, Public and Private insurance companies, SFCs, SIDCs, SIICs , etc are all classified as financial institutions and form a part of the formal financial system. In the post reforms era, the nature and activity of these financial institutions have undergone substantial change. Banks have now taken up non bank activities and financial institutions have taken up banking functions. Most of the financial institutions now access the capital market for raising funds.

Financial Markets
Financial markets are a mechanism that enable the participants to deal in the financial assets / claims. The markets also provide a forum wherein the demands and requirements interact and set a price for such claims / assets. The main organized financial markets in India comprise of Money Market, Capital Market, Commodities Market and Forex Market. Financial markets can also be classified as Primary markets and Secondary Markets. While the primary market deals with new issues, the secondary market is for trading in existing or outstanding securities.

Financial Markets ( continued )

There are two components of the secondary market, namely, Over the Counter Market ( OTC ) and the Exchange Traded Market. The government securities market is an OTC market. In the OTC market, spot trades are negotiated and traded for immediate delivery and payment while in the exchange traded market, trading takes place over a trading cycle in stock exchanges ( like BSE and NSE ). Recently, derivatives market ( Exchange traded ) has also come into existence.

Financial Instruments
A financial instrument is a claim against a person or an institution for payment of a sum of money at a future date or a periodic payment in the form of an annuity, interest or dividend. Financial instruments could be in paper form or electronic form of dematerialized securities such as shares, bonds, debentures, notes etc. Most financial instruments are listed and traded on the stock exchanges. This distinct feature of the financial instruments has enabled the people to hold a portfolio of different financial assets which in turn help in reducing the risk. Different types of financial instruments are being evolved constantly to suit the changing risk and return preferences of different classes of investors.

Financial Instruments ( continued )

Savings and investments are linked through a wide variety of complex financial instruments known as Securities. Securities are defined in the Securities Contracts Regulation Act, 1956, and include shares, stocks, bonds, debentures and other marketable securities. Financial securities are financial instruments that are negotiable and tradable. Financial instruments differ in terms of liquidity, marketability, reversibility, type of options, risk, return and transaction costs. Financial instruments help financial markets and financial intermediaries to help move the funds from savers to users.

Financial Services
Financial services are those that help individuals and organizations with investing, lending, funding and borrowing, selling securities, making payments, and managing risk exposures in the financial markets. The major financial services are intermediation of funds, payment mechanisms, provision of liquidity in the financial system, risk management and financial engineering. Funds intermediating services link the saver and the borrower which in turn leads to capital formation. New channels of financial intermediation have come into existence as a result of advances in Information & Communication Technologies.

Financial Services
LIQUIDITY is essential for the smooth functioning of a financial system. Liquidity of financial claims is enhanced through trading in securities. Liquidity s provided by brokers who act as dealers by assisting both sellers and buyers and also by market makers who provide 2 way quotes. Financial services are necessary to manage risks in an increasingly complex global economy. They enable risk transfer and protection from risk. Risk transfer helps the financial system participants to move unwanted risks to others who are willing to take risks, like speculators. The speculators who take risk also need a platform to transfer risk to other speculators.

 In addition, the market participants need financial insurance to protect themselves from various risks such as exchange rate risks and interest rate risks. The producers of these financial services are the financial intermediaries such as Banks, Insurance Companies, Mutual Funds and Stock Exchanges etc. The financial services rendered by the financial intermediaries bridge the gap between the knowledge on the part of investors and the increasing complexity of the financial instruments and markets. Regulatory bodies like RBI, SEBI and IRDA etc protect the interests of the investors and other market participants. The securities market is regulated by the Ministry Of Corporate Affairs, Department of Economic affairs, RBI, IRDA, and SEBI.

Financial Services ( continued )

Functions Of A Financial System The main function of a financial system is to link the savers and
investors and thereby help the mobilization and allocation of the savings in the most efficient and effective manner. A financial system not only helps in selecting the right projects to be funded but also inspires the operators to monitor the performance of the investment. Financial markets and institutions help to monitor corporate performance and exert corporate control through the threat of hostile takeovers from underperforming firms. A sound financial system should also provide an efficient payment and settlement system. An efficient payment and settlement mechanism is crucial to the smooth functioning of the economy. Banks provide this through checks, promissory notes, bills, credit and debit cards, NEFT & RTGS etc and stock exchanges through depositories & clearing corporations.

Functions Of A Financial System ( cont One of the most important functions of a financial system is to )
achieve optimal allocation of risk bearing. It limits , pools and trades the risks involved in mobilizing the savings and allocating credit. An efficient financial system aims at containing the risks within acceptable limits. It lays down rules for operations of the system to reduce the risks. Risk reduction is achieved by holding diversified portfolios and proper screening of borrowers. Market participants gain protection from unexpected losses by buying financial insurance services. Risk is traded in the financial markets through financial instruments called Derivatives. are risk shifting devices which shift risk from those who have it but dont want it to those who are willing to accept it.

Functions Of A Financial System ( cont ) A financial system also makes available price related
information which helps the market participants to take economic and financial decisions. Such information helps the participants to form informed opinion about investment, divestments, reinvestment etc. A financial system also offers portfolio adjustment facilities. These are provided by financial markets and financial intermediaries. This involves a quick, cheap and reliable way of buying and selling financial assets. A financial system helps in the creation of a financial structure that lowers transaction costs, thus helping investors to raise the return from their assets. It also reduces the cost of borrowing, thus encouraging the people to save more. Lastly, a well functioning financial system also helps in deepening and broadening of the financial markets.

Key Elements Of A Sound Financial System

The basic elements of a sound financial system are 1) A strong legal & regulatory environment, 2) Stable Money, 3) Sound Public Finances & Public Debt Management, 4) A strong Central bank, 5) A sound banking system, 6) A well functioning securities market, and 7) A sound information and communication system. The importance of each of these elements is as under -

Key Elements Of A Financial System

1) Since finance is based on contracts, a strong legal and regulatory environment that strictly enforces laws can alone protect the rights and interests of the investors and other market participants. Hence a strong legal and regulatory environment is a fundamental requirement of a sound financial system. Stable money is an important constituent as it serves as a medium of exchange, a store of value ( a reserve of future purchasing power )and a standard of value for all the goods and services we may wish to trade in. Large fluctuations and depreciation in the value of money lead to financial crises and impede the growth of the economy.

2)

Key Elements Of A Financial System

3) Sound public finance includes setting and controlling public expenditure priorities and raising revenues adequate to fund them efficiently. Historically, these financing needs of the governments world over led to the creation of financial systems. Developed countries have sound public finances and public debt management practices, which result in the development of a sound financial system. 4) A central bank supervises and regulates the operations of the banking system. It acts as a banker to banks and to government , manages public debt and forex reserves and is the lender of last resort. The central banks monetary policy influences the pace of economic growth. Hence an autonomous central bank is a prerequisite for a sound financial system.

Key Elements Of A Financial System

5) A good financial system must also have a variety of banks both with domestic and international operations- together with an ability to withstand adverse shocks without failing. Banks are the core financial intermediaries in all countries. They perform diverse key functions such as operating the clearing & payment systems, and forex markets. The banking system is the main fulcrum to implement the monetary policy actions. The financial soundness of the banking system depends upon how efficiently they perform these functions. Hence, a healthy banking system is another key prerequisite of a sound financial system.

Key Elements Of A Financial System

6) Another fundamental element of a sound financial system is an efficient information and communication system. All the participants in the financial markets require information and need to communicate. A sound financial system can develop only when proper disclosure practices and networking of information systems are adopted. 7) Securities markets facilitate issue and trading of securities, both equity and debt. Efficient security markets promote economic growth by mobilizing and deploying funds into productive uses, lowering the cost of capital for firms, enhancing liquidity and attracting foreign investment. An efficient securities market strengthens market discipline by exerting corporate control through the threat of hostile takeovers of underperforming firms. Existence of efficient security markets, therefore, is also a key element of a sound financial system.

 A financial system is a vertical arrangement of a well integrated chain of financial markets and institutions that provide financial intermediation. Different designs of financial systems are found in different countries. The structure of the economy, its evolution, political, technical and cultural differences affect the design of the financial system. Two prominent designs can be identified from amongst the various designs that exist. At one end is the bank dominated system, such as in Germany, where a few large banks play a dominant part and the stock market is not so important. At the other end is the market dominated system, such as in the USA where markets play a dominant role and the banking system is not so much concentrated.

Financial System Designs

Financial System Designs

In the bank based financial systems, banks play a pivotal role in mobilizing savings, allocating capital, overseeing the investment decisions of corporate managers, and providing risk management facilities. In the market based financial systems, securities markets take center stage with banks in mobilizing the societys savings for firms, exerting corporate control, and easing risk management. Most of the other major industrial countries fall in between these two extremes. Bank based systems tend to be stronger in countries where governments have a direct hand in industrial development. In India, banks traditionally have been the dominant entities in financial intermediation. Nationalization of banks, administered interest rate regimes and the governments policy of favoring banks led to the predominance of a bank based financial system.

Financial System Designs

Strangely, there are bank based systems in some developed countries while there are market based systems even in some underdeveloped countries as shown hereunder --------------------------------------------------------------------------------------Level of development Bank based Market based ------------------------- ------------------------------------Developed Japan, Germany, USA, Singapore France, Italy Korea, Malaysia Argentina, Pakistan, Brazil, Mexico Sri Lanka, Bangladesh Turkey, Philippines --------------------------------------------------------------------------------------Underdeveloped

Comparison of Bank Based And Market Based Financial Systems

Given these two types of financial systems, questions arise about the advantages and disadvantages of a bank based system vis a vis market based system. Each system has its own merits and demerits. Proponents of market based system argue that 1) Efficiency is associated with the functioning of competitive markets. 2) Financial markets are attractive as they provide the best terms to both investors and borrowers. 3) Stock markets facilitate diversification and allow efficient risk sharing. 4) They provide incentive to gather information that is reflected in stock prices and these prices, in turn, provide signals for an efficient allocation of investment. 5) One important area in which financial markets perform differently from financial intermediaries is when a diversity of opinion exists such as the financing of new technologies or when an unusual decision has to be made. Hence, in emerging industries with substantial technological risks, a market based system may be preferable.

 A market based financial system has three drawbacks 1) It is more susceptible to volatility and instability. 2) Its investors are exposed to market risks. 3) There is a Free Rider problem. The last drawback arises when no individual is willing to contribute towards the cost of something but hopes that someone else will bear the cost. This problem arises wherever there is a public good and separation of ownership from control. For example, shareholders take little interest in the management of the companies, hoping someone else will monitor the executives. In a market based system, free rider problem blunts the incentives to gather information.

Drawbacks Of A Market Based Financial System

 On the other hand, a bank based system is perceived to be more stable, as the relationship with the parties is more close. This leads to the formation of tailor-made contracts and financial products and efficient inter-temporal risk sharing. Financial intermediaries can eliminate the risks that can not be eliminated at a given time , but can be averaged over time through inter-temporal smoothing of asset returns. This requires that investors accept lower returns than what market offers in some periods in order to get higher returns in other periods. This provides an insurance to the investors who would otherwise be forced to liquidate their assets at disadvantageous prices.

Market based Vs Bank based systems

 The banking system avoids some of the information deficiencies of the security markets. The free rider problem is eliminated as private incentives to gather information are higher in the case a bank based system. Moreover, banks can perform the screening and monitoring functions on behalf of the investors. These functions, left to themselves, can be undertaken only at a high cost. The greatest drawback of a bank based system is that it retards innovation and growth as banks have an inherent preference for low riskreturn projects. Moreover, powerful banks may collude with managements against other investors, which, in some cases could impede competition, effective corporate control and entry of new firms.

Market based Vs Bank Based Systems

Current Trends The Current trend all over the world is a preference for the

market based systems. France and Japan have reformed their markets to make them more competitive. It is partly due to the growing volume of banking activity in the financial markets. The European Union is moving towards single unified market to increase its global competitiveness. In India also , the role of stock markets has gained prominence in the post reforms period. The Government has put in substantial efforts to reform the financial markets. The Indian equity market is now on par with some of the most developed markets in the world. The ratio of market capitalization to the total assets of scheduled commercial banks has risen sharply from 28.4% in March 1991 to 79.3% in March 2000.

Current Trends ( continued )

The relative share of banks in the aggregate financial assets of banks and financial institutions taken together which stood at nearly 75% in early 1980s is now at 55%, implying that there is considerable potential for growth in market financing. Research economists have put forward two explanations for the universal popularity of market based systems i) Government intervention is regarded as a negative factor and government failures are as important a problem as market failures. ii) Economic theory, pertaining to firms, stresses the effectiveness of free markets in optimum allocation of resources.

 Empirical analysis in various researches do not suggest emphatically the superiority of one system over the other. Whatever be the type of financial system, both financial intermediaries and financial markets play a crucial role in the development of a sound financial system. Both systems can co exist as they encourage competition, help reduce transaction costs, and improve resource allocation within the economy fostering development of a sound financial system and over all economic growth.

Which One Is Better?

 Financial institutions are business organizations serving as link between savers and borrowers, and so help in the credit allocation process. Sound financial institutions are vital to the smooth functioning of any economy. History has shown time and again that countries with developed financial institutions grow faster and countries with weak financial institutions face financial crises. Lenders and borrowers differ in terms of risk, return and terms of maturity. Financial institutions assist in resolving this conflict between lenders and borrowers by offering claims against themselves and , in turn, acquiring claims against borrowers.

Nature And Role Of Financial Institutions & Financial Markets

Financial Institutions & Markets ( cont Financial institutions provide ) 3 transformational services 1) Liability, asset and size transformation consisting of mobilization of funds and their allocation by providing large loans on the basis of numerous small deposits.

2) Maturity transformation by offering the savers tailor made short term claims or liquid deposits and so offering to borrowers long term loans matching the cash flows generated by their investments.
3) Risk transformation by transforming and reducing the risk involved in direct lending by acquiring diversified portfolios.

 Through these services, financial institutions are able to tap savings that are otherwise unlikely to be acceptable. Moreover, by facilitating the availability of finance, financial institutions enable the consumers to spend in anticipation of future income and the entrepreneur to acquire physical capital. The role of financial institutions has undergone a tremendous change since the introduction of financial sector reforms in 1991. Besides providing direct loans, many financial institutions have diversified themselves into other areas of financial services such as Merchant Banking, Underwriting and Issue Of Guarantees.

Financial Institutions & Markets (cont)

Financial Markets
Financial markets are an important component of the financial system, They are a mechanism for the exchange trading of financial products under a policy framework. The participants in the financial market are the borrowers (issuers of securities ), lenders ( buyers of securities ) and financial intermediaries. Primarily, there are four major components of the financial market 1) The Money Market, 2) The Capital Market, 3) The Forex Market, and 4) The Commodities Market

The Money Market A Money Market is a short term debt market where the

debt instruments have maturity up to one year. It is a highly liquid market wherein securities are bought and sold in large denominations to reduce transaction costs. Call Money Market, Certificates of Deposits, Treasury Bills and Commercial Paper are the major instruments in the Money market. The important functions of the Money Market are i) To serve as an equilibrating mechanism to redistribute cash balance in accordance with the liquidity needs of the participants, ii) To form the basis for the management of liquidity and money in the economy by monetary authorities, and iii) to provide reasonable access to the users of short term

 The Capital Market is a market for long term securities equity and debt . The purpose of the Capital Market is to 1) Mobilize long term savings to finance long term investments, 2) Provide risk capital in the form of equity or quasi-equity to entrepreneurs, 3) Encourage broader ownership of productive assets, 4) Provide liquidity with a mechanism enabling the investor to sell financial assets, 5) Lower the costs of transactions and information, and 6) Improve the efficiency of capital allocation through a competitive pricing mechanism.

The Capital Market

Money Market & Capital Market

There is a strong link between the Money market and the Capital Market as under 1) Often, financial institutions actively involved in the Capital Market are also involved in the Money Market. 2) Funds raised in the money market are used to provide liquidity for long term investment and redemption of funds raised in the capital market. 3) In the development process of financial markets, the development of money market typically precedes the development of the capital market. 4) Capital Market is further classified into primary Market and Secondary Market. Primary Market is for new issues while Secondary Market is for trading in existing outstanding securities. A vibrant secondary market is essential to drive the primary markets.

Primary Market & Secondary Market

Even though secondary market is many times larger than the primary market, they are interdependent on each other in many ways 1) The primary market is meant for new issues (IPOs). But the volume, pricing and timing of new issues is influenced by the returns in the secondary market. 2) Returns in the stock market depend on macroeconomic factors. Favorable macroeconomic factors help the firms earn higher returns which in turn create favorable conditions for the secondary market. This, in turn, affects the market prices of stocks. 3) Moreover, favorable macroeconomic factors also necessitate fresh capital raising to finance new projects as also expansion and modernization of existing projects. A buoyant secondary market , in turn, promotes the primary market.

Primary & Secondary Markets ( continued )

3) The secondary market also provides a basis for the determination of prices at which new issues can be offered in the primary market. 4) The depth of the secondary market depends upon the activities in the primary market, because, bigger the entry of corporate entities in the primary market, larger is the number of instruments available for trading in the secondary market. 5) New issues of a large size and bunching of issues may divert funds from the secondary market to the primary market, thereby temporarily depressing stock prices.

Characteristics Of Financial Markets

1) Financial Markets are characterized by a large volume of transactions and the speed with which financial resources move from one market to another. 2) There are various segments of financial markets such as Stock markets, bond markets, primary and secondary markets, where savers themselves decide when and where they should invest money. 3) There is scope for instant arbitrage among various markets and types of instruments. 4) Financial markets are highly volatile and susceptible to panic and distress selling as the behavior of a limited group of operators can get generalized.

Characteristics Of Financial Markets ( cont )

5) Markets are dominated by financial intermediaries who take investment decisions as well as risk on behalf of their depositors. 6) Negative externalities are associated with financial markets. A failure in any one segment of the market may affect other segments, including non financial markets. 7) Domestic financial markets are getting integrated with global financial markets. The failure and vulnerability in a particular domestic market can have international ramifications in a globalised world. In view of the above characteristics, financial markets need to be closely monitored and supervised.

Functions Of Financial Markets The cost of acquiring information and making transactions

creates incentives for the emergence of financial markets and institutions. Different types and combinations of information and transaction costs motivate distinct financial contracts, instruments and institutions. Financial markets perform various functions as under 1) Enabling economic units to exercise their time preference, 2) Separation, distribution, diversification and reduction of risk, 3) Operating efficient payment and settlement mechanisms, 4) Providing information about companies. This spurs investors to make inquiries themselves and keep track of companies activities with a view to trading in their stock efficiently, and 5) Transmutation or transformation of financial claims to suit the preferences of both savers and borrowers.

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